Universal Banking in an Emerging Economy: The Conflict-of-Interest Hypothesis

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1 Unversal Bankng n an Emergng Economy: The Conflct-of-Interest Hypothess Chh-Pn Ln, Drector, Department of Busness Admnstraton, Alethea Unversty, Tawan ABSTRACT Past research on unversal bankng, or the practce of provdng multple fnancal servces under the same roof, has varous fndngs. Some studes have found synerges n unversal bankng, whle others have found conflcts of nterest. Drawng on nsttutonal-based vew, I hypothesze that unversal bankng n emergng economes such as Tawan gves rse to conflcts of nterest. Because market-supportng nsttutons n emergng economes are less developed, unversal bankng there are more lkely to result n conflcts of nterest. Data from 211 IPO frms provde evdence for the hypothess. Implcatons for both managers and regulators and future research drectons are provded. Keywords: Unversal bankng; fnancal holdng companes; conflcts of nterest; nsttuton-based vew; multple agency theory INTRODUCTION Unversal bankng has been prohbted n the Unted States snce 1933, when the Glass-Steagall Act was enacted to forbd commercal banks from engagng n underwrtng corporate securtes, separatng commercal bankng, and nvestment bankng (underwrtng). Underlyng ths separaton was the belef that combnng commercal bankng and underwrtng would result n conflcts of nterest (Benston, 1996). For example, when a commercal bank fnds out that the default rsk of a loan clent frm has ncreased, t could underwrte securtes for that clent frm, sell the securtes to naïve nvestors, and ask the frm to repay the loan to the bank usng the proceeds receved by ssung the securtes, thus transferrng the ncreased default rsk to the naïve nvestors (Kroszner and Rajan, 1994; Kroszner, 1996; Rajan, 1996). However, the Glass-Steagall Act has been gradually repealed snce the late 1980s, and was fnally replaced by the Fnancal Servces Modernzaton (Gramm-Leach-Blley) Act of 1999, whch permts the establshment of fnancal holdng companes (FHCs; a specal knd of unversal banks) that own commercal banks, underwrters, and other fnancal nsttutons smultaneously. At about the same tme, several other countres also removed the regulatons that separate commercal bankng and underwrtng, ncludng Canada, Japan, and Tawan. The Glass-Steagall Act was repealed n part due to the belef that ntegratng commercal banks, underwrters, and other fnancal nsttutons under the same roof would yeld synerges. For nstance, when a commercal bank makes loans to a clent frm, the bank must ncur substantal costs nvestgatng the clent frm s credt. Meanwhle, the underwrter also needs credt nformaton regardng the ssung frm when provdng underwrtng servces. If credt nformaton gathered by the bank can be transferred to the afflate underwrter wthn an FHC, the underwrter can access more nformaton about that clent frm when provdng underwrtng servce to that frm, thereby reducng the probablty that the underwrtten securtes turn out to be low-performng and creatng synerges. Past research has argued that f conflcts of nterest domnate unversal bankng, nvestors wll dscount the prces of securtes underwrtten by bank-afflated underwrters; by contrast, f synerges outwegh conflcts of nterest, nvestors wll pay hgher prces to buy the securtes underwrtten by bank-afflated underwrters. Whether synerges or conflcts of nterest domnate unversal bankng s an emprcal queston (Pur, 1994; 1996; Hebb and Fraser, 2002; Ber et al., 2001; Kroszner and Rajan, 1994). However, the emprcal results are vague. Some studes have found that conflcts of nterest predomnate (Ber et al., 2001; Kang and Lu, 2007; Agarwal and Elston, 2001), whle others found that synerges are more salent (Pur, 1994; 1996; Gande et al., 1997; Kroszner and Rajan, 1994; Hebb and Fraser, 2002; Jensen, 2003).

2 Drawng on the nsttuton-based vew and multple agency theory, ths study argues that n countres where market-supportng nsttutons are less developed, unversal bankng may result n conflcts of nterest. Insttutons can be broadly defned as the formal and nformal rules of the game (North, 1990; Peng et al., 2008). Ths study focuses on formal nsttutons, such as market-supportng regmes or market nsttutons (Meyer et al., 2009), and argues that formal nsttutons play crucal roles n determnng synerges and conflcts of nterest n unversal bankng. The multple agency theory models agency relatonshps among a group of agents and prncpals, and at least one of the agents s connected wth two or more prncpals (Arthur et al., 2008). Multple agency relatonshps, when combned wth nsttutons, determne whether synerges or conflcts of nterest do present n a unversal bank. Thus, ths study contrbutes to the nsttutonal-based vew by argung that one form of organzatons (.e., unversal banks or FHCs), when embedded n dfferent nsttutonal contexts, can produce two contrary results (.e., synerges and conflcts of nterest); namely, nsttutons do matter. The study addresses the followng research questons: (1) How do nsttutons and multple agency relatonshps nterplay to determne synerges and conflcts of nterest n unversal bankng? (2) Where and when does unversal bankng create synerges or conflcts of nterest? (3) Does unversal bankng n Tawan result n synerges or conflcts of nterest? Usng data from 211 ntal publc offerng (IPO) frms n Tawan from , ths study emprcally tests the hypotheses. Tawanese IPO frms offer promsng research data for ths agenda because they are often small, young, and entrepreneural, characterstcs that make nformaton regardng frm credt and prospects dffcult to access. The resultng ncreased nformaton asymmetry among IPO frms, banks, underwrters, and market nvestors n turn ncreases both potental synerges and conflcts of nterest n unversal bankng. Furthermore, because t s wdely beleved that market nsttutons n Tawan are less developed than those n the Unted States (Luo and Chung, 2005; Chuang and Ln, 2008), the research results can be compared to those of pror research that uses U.S. data. THEORY AND HYPOTHESIS As I have noted, a unversal bank s a fnancal nsttuton that provdes commercal bankng, underwrtng, and other fnancal servce under the same roof (Saunders and Walter, 1994). A fnancal holdng company (FHC) s a unversal bank that provdes varous fnancal servces wth separately captalzed afflates, whch are beleved to mtgate some potental conflcts of nterest (Kroszner and Rajan, 1997). Past research n both the fnancal and manageral lterature has demonstrated that mnglng commercal bankng and underwrtng creates synerges. Usng U.S. data from before the Glass-Steagall Act, Kroszner and Rajan (1994) found that corporate bonds underwrtten by commercal banks had a lower default rate than those underwrtten by ndependent underwrters. They argued that the lower default rate mght result from the nformaton advantages that commercal banks enjoy over ndependent underwrters. Through prevous loan transactons, a commercal bank may have credt nformaton regardng a certan loan clent that an ndependent underwrter lacks. Consequently, a commercal bank can better overcome nformaton asymmetry when provdng underwrtng servce to that clent frm than an ndependent underwrter can (Rajan, 1996; Kroszner, 1996; Kanatas and Q, 2003). Other research n the Unted States that employed both pre-glass-steagall and recent data has confrmed ths result (Pur, 1994; 1996; Gande et al., 1997), as has Canadan data. Analyzng the Canadan corporate bonds ssued after a 1987 deregulaton that permtted commercal banks to underwrte corporate bonds, Hebb and Fraser (2002) found that the yelds of bonds underwrtten by commercal banks are sgnfcantly lower (.e., prces are hgher) than those of smlar bonds underwrtten by ndependent underwrters. They argued that bank-underwrtten bonds have lower yelds (hgher prces) because nvestors beleve banks have better knowledge about ther clents and perceve less default rsk regardng these bonds, and thus ask for lower yelds and are wllng to pay hgher prces. However, other research, usng data from outsde North Amerca, has demonstrated conflcts of nterest n unversal bankng. For example, Ber et al. (2001) used Israel data and found that unversal bankng that mxes commercal bankng, underwrtng, and fund management results n conflcts of nterest; specfcally, IPO frms whose underwrters were also ther lendng banks showed sgnfcant lower frst-day returns. When IPO frms equty was

3 purchased by the mutual funds managed by the underwrter lender, the frst-day returns were even lower. The researchers argued that because unversal banks could underwrte lemons (.e., bad goods that cannot be dentfed by buyers ex ante; Akerlof, 1970) and shft the heghtened credt rsk from banks to naïve publc nvestors, nvestors would dscount the equty prces underwrtten by unversal banks. Smlarly, usng German data, Agarwal and Elston (2001) found that frms that are strongly ted to banks pay hgher nterest rates to ther banks than frms wthout such tes do. Ths suggests that a conflct of nterest results when a unversal bank smultaneously holds debt and equty n a frm. When ths s the case, the bank wll requre the frm to pay a hgher nterest rate to the bank frst, and then dstrbute remanng earnngs to the bank and other shareholders accordngly. And when Kang and Lu (2007) analyzed recent Japanese data, they found that unversal banks wll leverage ther monopoly power by depressng the prces of the securtes ssued by borrowng frms and underwrtten by these banks n order to favor the nsttutonal nvestors who purchase the securtes. Ths study mantans that unversal bankng n countres where market-supportng nsttutons are less developed create conflcts of nterests, rather than synerges. When an underwrter receves credt nformaton from a bank wthn an FHC, whether the underwrter wll underwrte good (synergy hypothess) or bad (conflct-of-nterest hypothess) securtes to sell to nvestors depends on the multple agency relatonshps among the FHC, the underwrter, and nvestors. Although the underwrter n an FHC s an agent that operates underwrtng actvtes for the FHC (the prncpal), t s also an agent to the nvestors (the prncpals) who purchase securtes from the underwrter, thus creatng a multple agency relatonshps. The underwrter must decde whch prncpal s (the FHC s or nvestor s) nterests to serve. I argue that, because the FHC montors the underwrter better than nvestors do, the underwrter wll serve the FHC s nterests more than those of nvestors. Consder that the underwrter and the FHC belong to the same frm, and that nformaton and knowledge are more easly transferred wthn a frm than across a market (Kogut and Zander, 1993; Almeda et al., 2002; Kachra and Whte, 2008; Teece, 1986). When the FHC s famly owned, ts afflates can be connected by famly or other pluralstc tes, further facltatng the nformaton flow (Luo and Chung, 2005; Peng et al., 2005; Khanna and Palepu, 2000). By contrast, nvestors montor the underwrter through external captal markets, whch are usually less effcent than the nternal captal market (Wllamson, 1975; Teece, 1982). Consequently, an FHC underwrter wll serve the FHC more than t wll serve nvestors. From among the afflated bank loan clents, t wll choose the clent frms n whch default rsks have ncreased and underwrte them to shft the default rsk from the FHC to naïve nvestors, resultng n a conflct of nterest. Conflcts of nterest wll be partcularly salent where market nsttutons are less developed, n that nvestors montor underwrters through external captal market. When market nsttutons are weak or less developed, t s more dffcult for nvestors to montor underwrters, and thus underwrters wll serve more for the FHCs than for nvestors, resultng n conflcts of nterest. It has been reported that the market nsttutons n Tawan are less developed than those n the Unted States (Luo and Chung, 2005; Chuang and Ln, 2008; Hamlton, 1997). Because market nsttutons are less developed n Tawan and nvestors cannot effcently montor FHC underwrters through captal market, ths study argues that the conflct-of-nterest hypothess wll hold n Tawan. By contrast, n countres where market nsttutons are well establshed, such as the Unted States and Canada, underwrters n FHCs are better montored by market nvestors; thus, synerges, rather than conflcts of nterest, may be salent. Synerges or conflcts of nterest wll ultmately be reflected n the stock prce or the frst week returns of the IPO frm underwrtten by FHC underwrters. When market nvestors perceve conflcts of nterest that FHC underwrters wll leverage ther nformaton advantage and sell lemon to shft ncreased default rsk to them, they wll dscount the securtes prces and thus the frst week returns wll be lower (Pur, 1994; 1996; Hebb and Fraser, 2002; Ber et al., 2001). Because nvestors n Tawan perceve conflcts of nterest n FHCs, as argued above, ths study predcts that the frst week returns of IPO frms underwrtten by FHC underwrters are lower. Hypothess 1: In countres where market-supportng nsttutons are less developed, such as Tawan, the frst-week stock return of an IPO frm whose lead underwrter and lender bank belong to the same FHC wll be lower than that of other IPO frms.

4 METHODS Sample Usng data from 211 ntal publc offerng (IPO) frms n Tawan from 2003 to 2005, ths study tests the hypothess above. The analyss begns n 2003 because, although the FHC Act came nto effect n November 2001, t was not untl January 2, 2003 that all 14 FHCs were establshed. The ffteenth FHC, Tawan FHC, a state-owned FHC, was establshed n 2008; because t falls outsde of the sample perod, t s excluded from ths study. In addton to the 14 FHCs establshed durng the sample perod, the Tawan Industral Bank s also ncluded. The Tawan Industral Bank engages n commercal loans; t also owns a securtes afflate that performs underwrtng. Because t engages n unversal bankng, t s ncluded n ths study s defnton of FHCs. The source of the data was the Tawan Economc Journal. Measures Dependent Varables Ths study uses the frst-week returns after the IPO to measure nvestor perceptons of synerges and/or conflcts of nterest n the stock market. Tradtonal frst-day returns are not applcable n ths study gven a seven percent maxmum-change-rate constrant on the frst tradng day n Tawan durng the sample perod. Ths study calculates both the straght frst-week returns (R1) and the frst week abnormal returns (AR1). The frst-week return s the dfference between the closng prce of the ffth tradng day and the offer prce, dvded by the offer prce of the IPO stock. To calculate the frst-week abnormal returns, ths study uses the followng one-factor model R R t where R t s the weekly return on the stock of frm n week t; R the weekly return on market portfolo n week t; mt the measure of market rsk; the ntercept; t the error term and abnormal return for frm n week t. Usng returns n the frst to 52th weeks durng 2007, ths study estmates and. Fnally, the frst-week abnormal return, AR1, s t. Independent Varables The pror lendng te s whether or not an IPO frm borrows from afflate banks of the FHC whose afflate underwrter s also the lead underwrter of that IPO wthn two years before the IPO date. If yes, the varable s equal to 1; otherwse, t s equal to 0. Control Varables Ths study controls the IPO frm sze, whch s measured by the natural log of total assets of the IPO frms at the end of the prevous year before the IPO date. Ths study also controls the lead underwrter status, measured by the number of cases underwrtten by the lead underwrter of an IPO case n the prevous year of the IPO date (Hebb and Fraser, 2002; Gulat and Hggns, 2003). Fnally, because I employ panel (tme-seres cross-secton) data, whch usually result n the problem that data are dependent wthn the same year, I mpose a dummy varable on each year, whch s the fxed effects approach for panel data (Greene, 2000). Statstcal model Usng the followng regresson model, ths study tests the hypothess emprcally. y 0 1Lendngte 2Underwstatus 3Sze 4Year2004 5Year2005 Where y s are the frst-week returns and the frst-week abnormal returns. mt RESULTS t Table 1 demonstrates the means, standard devatons, and correlatons of varables. Table 2 demonstrates the results OLS estmates. The dependent varables n Model 1 and Model 2 are the frst-week returns of the IPOs; the dependent varables n Model 3 and Model 4 are the frst-week abnormal returns. Model 1 and Model 3 contan only control varables, and the man varable n ths study s added n Model 2 and Model 4. Note that the results of Model 2

5 and Model 4 are qute smlar. The Pror lendng tes have sgnfcant negatve effects n both Model 2 and Model 4, supportng the conflct-of-nterest hypothess. Table 1: Means, standard devatons, and correlatons of varables Mean S.D Frst week return (R1) Frst week abnormal return(ar1) Pror lendng te Underwrter status ln(total assets) Year dummy Year dummy Table 2: Results of the splne and modfed splne regressons Varables Frst week return (R1) Frst week abnormal return (AR1) Model 1 Model 2 Model 3 Model 4 Pror lendng te ** * (3.45) (3.48) Underwrter status (0.16) (0.16) (0.16) (0.16) ln(total assets) 2.28 ** 2.33 ** 2.26 ** 2.30 ** (1.12) (1.12) (1.13) (1.13) Year dummy ** 5.98 ** 5.45 ** 5.54 ** (2.65) (2.64) (2.66) (2.66) Year dummy *** *** *** *** (3.79) (3.78) (3.81) (3.82) Intercept * ** * * (15.98) (15.91) (16.09) (16.04) R squared Adjusted R squared F 9.31 *** 8.07 *** *** 8.60 *** N=211. One taled tests for man varables; two taled tests for control varables. Standard errors are n the parentheses; the based year s *p<0.1 **p<0.05 ***p<0.01 DISCUSSION Ths study dstngushes where unversal bankng creates synerges and where t results n conflcts of nterest, whch le n the underwrter decson n multple agency relatonshps. In multple agency relatonshps (Arthur et al., 2008) among an FHC, underwrter, and market nvestors, the underwrter wll serve the nterest of the prncpal that montors t better. The FHC montors the underwrter through a herarchcal relatonshp, whle nvestors montor t through a market relatonshp. Thus, the underwrters wll favor market nvestors and underwrte good securtes for them (the synergy hypothess) only n countres where market nsttutons are well developed and nvestors montor underwrters effcently, as n the Unted States and Canada. Kroszner and Rajan (1994), Pur (1994; 1996), Gande et al. (1997), and Hebb and Fraser (2002) have all found synerges n unversal bankng usng U.S. and Canadan data. However, n countres where market nsttutons are less developed, market nvestors montor underwrters less effcently than the FHCs do; thus, underwrters wll shft the ncreased default rsks from the FHCs to market nvestors, resultng n conflcts of nterest. Ber et al. (2001) have found that unversal banks n Israel shft the default rsks to equty nvestors. Smlarly, the present study fnds that FHCs n Tawan shft the ncreased default rsks that they absorb to market nvestors.

6 Germany and Japan, though developed countres, have bank-based fnancal systems rather than the type of market-based system seen n the Unted States (Stenherr, 1996). In a bank-based system, unversal banks montor frms far better than market nvestors do because they mantan long-term relatonshps wth clent frms and hold both debt and equty of the frms (Hosh, 1996; Gorton and Schmd, 2000). Thus, the multple agency relatonshps among the frm (the agent), the bank, and nvestors (both of whch are prncpals to the frm n that they provde t wth captal) prompt frms to serve the unversal bank more than market nvestors, because the unversal bank montors the frm better than the nvestors do. Agarwal and Elston (2001) found that German unversal banks, whch hold both the debt and equty of frms, requre frms to pay hgher nterest rates at the expense of other equty holders of the frms. The results of Kang and Lu (2007) can also be nterpreted by the theory developed n ths study. In the multple agency relatonshps among the bank underwrter (agent), ssung frm, and nsttutonal nvestors (both of whch are the prncpals to the bank underwrter, n that the ssung frm hres the underwrter for underwrtng servces and nvestors purchase securtes underwrtten by the underwrter), nsttutonal nvestors montor the bank underwrter through long-term relatonshps. However, the ssung frm cannot montor the bank underwrter. Instead, the ssung frm s montored and controlled by the unversal bank, whch holds both debt and equty of the ssung frm. In other words, the bank s the boss and the ssung frm s ts subordnate. Thus, t s not dffcult to recognze why Kang and Lu (2007) found that Japanese bank underwrters depress the prces of the securtes they underwrte to favor the nsttutonal nvestors at the expense of the ssung frms. On the other hand, n a market-based system such as that n the Unted States, frms are not tghtly controlled by unversal banks and retan more autonomy. Therefore, frms can serve banks and nvestors n a more balanced way and can reject bank underwrters depressng the prces when ssung securtes. Thus, conflcts of nterest found by Agarwal and Elston (2001) and Kang and Lu (2007) are not found n the Unted States. CONCLUSION Ths study has successfully predcted that FHCs n countres where market nsttutons are weak, such as Tawan, gve rse to conflcts of nterest by combnng commercal banks and underwrters. To decrease conflcts of nterest, I propose that governments should mprove market nsttutons that allow market nvestors to montor both frms and unversal banks. More detaled plans to mprove market nsttutons need further research. Ths study not only ncreases our understandng to the phenomenon that unversal bankng creates synerges and conflcts of nterest, but also contrbutes to the theory development. In partcular, ths study contrbutes to the nsttuton-based vew by demonstratng that nsttutons do matter. One organzaton form, such as a unversal bank, can result n two contrary consequences when t s embedded n dfferent nsttutonal contexts. In countres where market nsttutons are well-developed, such as the Unted States and Canada, unversal banks can brng about synerges, whle n countres where market nsttutons are less-developed, such as Tawan and other emergng economes, the same unversal banks may result n conflcts of nterest. Insttutons do matter, partcularly when combned wth multple agency theory. Further research from nsttuton-based vew s promsng. REFERENCES Agarwal, R. and Elston, J. (2001) Bank-frm relatonshps, fnancng and frm performance n Germany. Economcs Letters, 72: Akerlof, G. (1970) The market for lemons : Qualty uncertanty and the market mechansm. Quarterley Journal of Economcs, 84: Almeda, P., Song, J. and Grant, R. M. (2002) Are Frms Superor to Allances and Market? An Emprcal Test of Cross-Border Knowledge Buldng. Organzaton Scence, 13(2): Arthur, J.D., Hosksson, R.E., Busentz, L.W., and Johnson, R.A. (2008) Manageral agents watchng other agents: Multple agency conflcts regardng underprcng n IPO frms. Academy of Management Journal, 51(2): Benston, G. (1996) The orgn and justfcaton for the Glass-Steagall Act. In A. Saunders and I. Walter (Eds.), Unversal bankng: Fnancal system desgn reconsdered, pp , Chcago: Irwn. Ber, H., Yafeh, Y. and Yosha, O. (2001) Conflct of nterest n unversal bankng: Bank lendng, stock underwrtng, and fund management. Journal of Monetary Economcs, 47: Chuang, C.-M. and Ln, C.-P. (2008) Socal captal and cross-sellng wthn fnancal holdng companes n an emergng economy. Asa Pacfc Journal of Management, 25(1): Dunnng, J.H. (2009) Locaton and the multnatonal enterprse: John Dunnng s thoughts on recevng the Journal of Internatonal Busness Studes

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